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Deciphering the Code

A recent case that ostensibly dealt with a bank’s deductions for
interest and other expenses associated with tax-exempt income could
affect how advisers approach interpretation of the Code and revenue
rulings generally.

PSB Holdings is the parent of an affiliated group that includes
Peoples State Bank, which is based in Wausau, Wis. It also includes
Peoples’ wholly owned subsidiary, PSB Investments Inc., which handles
investment of the bank’s stock and bond portfolio. Code section 265(b)
requires financial institutions to allocate a pro rata portion of
their interest expense to the average adjusted bases of their
tax-exempt obligations acquired after Aug. 7, 1986. In calculating its
nondeductible interest under the section, Peoples included in its
consolidated returns for 1999 through 2002 the value of the stock of
PSB Investments in its assets but excluded the tax-exempt obligations
purchased and owned by PSB Investments. The government asked the Tax
Court to include the tax-exempt investments owned by the subsidiary in
the pro rata computation. The court ruled for the bank, saying it had
no adjusted bases in the tax-exempt obligations of its subsidiary.

The court noted that the subsidiary was formed to improve
efficiency, safeguard and manage the investment portfolio,
and—organized in Nevada—minimize state taxes. The court also noted the
IRS accepted these reasons as reflecting a sufficient business purpose
to avoid any sham or economic substance arguments.

In applying section 265(b), the court said the wording of the Code
shall be followed directly unless the wording is ambiguous or the
result would be absurd or thwart congressional intent. The
congressional intent behind section 265(b) was to raise revenue,
prevent abuse and provide certainty and reasonableness in calculating
an interest deduction, which the taxpayer’s narrow reading of the
section did not thwart, the court said. The court also pointed out
that Congress used the singular noun “taxpayer,” which limits the
computation solely to the bank corporation’s assets. The court also
noted a subparagraph of § 265(b) refers to a corporation and its
affiliates, thus proving, the court said, that Congress was aware of
the correct wording to combine corporations.

Perhaps most significantly, the court refused to follow Revenue
Ruling 90-44, which provides guidance on section 265(b). According to
the court, revenue rulings are entitled only to the deference paid
them under Skidmore v. Swift & Co. , 323 U.S. 134 (1944):
The court will honor the government’s interpretation only to the
extent its reasoning is persuasive, analysis complete and results
consistent with prior rulings and decisions. In effect, the Tax Court
treated the revenue ruling as the government’s litigation position.

This decision can have far-reaching implications, given the change
in section 6694 to requiring a more-likely-than-not standard of tax
return preparers for undisclosed items. It authorizes minimizing the
weight given to revenue rulings and permits taxpayers to argue that
where the words of the Code are not ambiguous they can be followed
exactly as written, even if the results are not completely in step
with the broadest interpretation of congressional intent. It may also
permit taxpayers to argue that state tax savings are a valid business
purpose to avoid sham transactions and economic substance issues.